SIMON FRASER ECON291 Lecture Notes - Stabilization Policy (1)

SIMON FRASER ECON291 Lecture Notes - Stabilization Policy (1)

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Stabilization Policy I. Stabilization policy: Keynesian vs classical views Q: Should the government act to smooth out business cycles? Classical View: (1) Prices and wages are fully flexible (2) All markets are (almost) always in equilibria (3) Business cycles are optimal response of economy to external shocks (4) Government intervention can make situation worse off (5) Government should leave the economy alone Example: Robinson Crusoe Economy Keynesian View: (1) Not all prices and wages are fully flexible (2) Supply is not equal to demand in all markets (3) In the long run, market can adjust itself (4) But long run is too long to wait (5) Government intervention can achieve the efficient outcome very quickly. Suppose that investors are pessimistic about the future and desired investment falls as a result. Let’s use the IS-LM model to analyze what will happen to the output, price level, employment, and real wage. 1
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Real interest rate, r FE LM IS1 IS2 Y1 Y2 r2 r1 Aggregate demand decreases as the desired investment decreases. Price level falls. Since nominal wage rate is fixed in the short run, the real wage will increase. There is excess supply of labor in the labor market. Employment level is lower than before. Economy is not in the general equilibrium. Option 1: do nothing (leave the economy alone) In the long run, the nominal wage falls to clear labor market. Price level will fall. Real money supply increases. LM will shift right, and economy is back to the general equilibrium. 2
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SIMON FRASER ECON291 Lecture Notes - Stabilization Policy (1)

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